FedEx Blog

FedEx Blog

Ponzi Scheme, Pyramid Scheme, Bubble, and the Importance of Endogenous Growth

December 16, 2008

There has been a lot of discussion in the media about Ponzi schemes.  In fact, some economists have been debating whether we were facing a system-wide Ponzi scheme as financial imbalances that rely on new investors (including those overseas) could not last forever. A scheme needs a schemer, but this, of course, is not the case for the financial system at a macro level.  If we look at practices at a micro level, including the situation in the housing market, fraudulent practices and schemers did exist.

So What is a Ponzi Scheme?
A Ponzi scheme is an investment operation that involves paying abnormally high returns to investors out of the money paid in by subsequent investors, rather than from the profit from any real business. The perpetuation of high returns requires an ever-increasing flow of money from investors, which is eventually unsustainable.

In a Ponzi scheme, the schemer acts as a “hub” for the victims, interacting with all of them directly and claiming some esoteric investment approach. This is different from a better known scheme called a “pyramid scheme” where recruiters benefit directly and make explicit claims that new money will be the source of payout for the initial investments.  Both schemes will lead to an inevitable collapse.

What About a Bubble?
A bubble is different in that it exists in an open market without schemers  In the case of a bubble, as long as buyers are willing to pay ever-increasing prices, sellers can get out with a profit. This follows the line of the “greater fool” theory, as manifest in dot-coms and housing in the past ten years. Bubbles can arise without any fraud at all, being caused by money supply expansion beyond what genuine capital investment supports, and in this case would mimic a Ponzi or Pyramid scheme, with expanding credit taking the place of an expanded pool of investors.

Many areas of financial imbalance in the system share the characteristic that smooth operations would rely on continued inflows from participants (domestic and/or international).  There may be no schemer here, but the results for the system are the same – an ultimate collapse once the limit of finite resources is reached.

Restoring Sustainable Growth
The current crisis is a testimonial that the U.S. economy needs to refocus on endogenous growth in order to restore growth sustainability. This can be achieved by restoring domestic savings, improving the rate of technological progress and increasing productivity. Policy measures can have an impact here, particularly in the areas of research and development, education, and innovation incentives, among others.  It is also important for the financial sector to play its role as an intermediary and facilitator for the real sector in order to achieve a higher and sustainable rate of return via endogenous growth, rather than focusing on short-term strategies that do little to enhance productive capabilities and are eventually unsustainable.

Without a doubt, it is difficult to tell what lies ahead by looking at the rearview mirror. Right now the economy is undergoing painful adjustments from bubbles and fraud. Most of the economic issues facing us today still fall within the context of basic economic logic we’ve learned in history. The applications and details may differ, yet principles remain unchanged.  In 55 BC Roman orator and politician Cicero pointed out:

“The national budget must be balanced. The public debt must be reduced; the arrogance of the authorities must be moderated and controlled. Payments to foreign governments must be reduced, if the nation doesn’t want to go bankrupt. People must again learn to work, instead of living on public assistance.”

This is a statement made over two millennia ago. Sound familiar? There are plenty of reasons to be a good student of history.

Here I offer a New Year’s resolution for the economy: regroup, rebalance, and refocus on endogenous growth.  We need to be accountable for our children; we need to strengthen our industrial base through innovations; we need sustainable growth, not just growth.


Comments

    Jim says:

    The quote from Cicero is awesome. Thank you for defining a Ponzi Scheme, I’ve been hearing it on the news, but nobody explained what it was.

    Saji says:

    I am horrified about the system-wide Ponzi scheme we are facing – We are ripping the rule book and flying blind. Our official debt is over 10 Trillion Dollars (vs. the annual US GDP is around $14 Trillion). If we include Medicare & Social security obligations, it is around $50Trillion – According to David Walker (comptroller general of the United States and head of the US Government Accountability Office), “the nation’s total liabilities and unfunded commitments for pension and health programmes for the elderly (Social Security and Medicare, respectively) have mushroomed from about $20,000bn to about $50,000bn in the six-year period ending in fiscal 2006” (http://www.ft.com/cms/s/0/f98a1f4e-4fef-11dc-a6b0-0000779fd2ac,dwp_uuid=1903fc22-a717-11dc-a25a-0000779fd2ac.html). I don’t even want to imagine the mess we tax payers (US Treasury) likely to inherit from the Banks and other financial systems– CDO’s itself is estimated around $62 Trillion.

    Till now rest of the world (primarily EAST) supported this scheme by buying the Treasury bonds (and mortgage linked securities)– even for no return considering the new Fed rate. I am afraid that trend is reversing or crumbling down considering the USD is devaluing against the foreign currencies since the Fed rate decision. I may suggest to take a look at The FT Year In Finance – http://www.ft.com/reports/year-in-finance or at http://media.ft.com/cms/b362ea0c-c873-11dd-b86f-000077b07658.pdf

    I try not to listen to Jim Rogers, George Soros etc. on their predictions. As George Washington mentioned, we should avoid “ungenerously throwing upon posterity the burdens that we ourselves ought to bear”. You may visit an interesting article by Warren Buffet published in Fortune Magazine back in 2003 – http://www.berkshirehathaway.com/letters/growing.pdf

    But I am an optimist – this country belongs to hardworking men & women and we learn from this crisis and will come back stronger than ever.

    Nicholas P says:

    For decades now the US economy has been lurching from one bubble to another with periods of busts intervening. I think the common people first became familiar with the term ‘bubble’ during the dot.com bust, but this pheniomenon started much earlier and has now become stystemic in our economy. Thanks Gene for summarizing it so well, as well as pointing to the way out.
    I am still curious about one thing: what can be considered a healthy rate of endogenous growth for the economy? 3-4% ? If that is the case then I think any insvestment vehicle that promises much higher rates of return either has mastered the art of picking the winners or falls in one of the cateogries of schemes that Gene describes.

    Jim says:

    I’m sorry, but I fail to see the difference between your “bubble” and a “ponzi scheme”. Both rely on the “greater fool”. This is what is in fact essential to both.

    No fraud involved in a bubble? That is ridiculous. The truth is that in both the “ponzi scheme” and the “bubble”, the people involved are racing to get in because they have an instinctual understanding it will not last forever. I for one am sick and tired of excuses being made.

    I remember speaking with a friend of mines father about six years ago. He asked me if I was planning on buying a home, and I told him not until prices come down. He actually looked me in the eye and said “that will never happen”. Are there really people out there who thought home prices could continue to climb by ridiculous percentages each year? I tried pointing out that my debt to income ratio would be insane if I bought a home now, but that didn’t seem to matter to him.

    This was an obvious unsustainable scheme from day one. If we were a country of even slightly ethical, responsible people, this would never have occurred. I lived with my girlfriend and our 70lb shepherd mix in a small two ROOM apartment for five years. We now have moved up to a two bedroom apartment, which costs slightly more but is still quite affordable. I sacrificed to get what I have now. I am supposed to give my life blood in taxes now after working for my future over the past 10 years, being patient and not falling into the trappings of “competing with the neighbor”? I think maybe I’ll start dedicating my intellectual resources toward tax evasion. I won’t be the ant for the winter stranded grasshopper.

    Mike says:

    Gene your comments are thoughtful and as always appreciated. I would like to comment however that the severe financial and economic distresses we are experiencing, certainly since Sep ’08 and even as far back as fall 2007, can be directly tied to the “individual decisions” made by so called policy “experts” and policy “wonks” in our Federal Legislative Branch, the Executive Branch (Treasury, HUD, SEC), and the pseudo Gov’t (Federal Reserve). Not “the market”, but a handful of very highly placed and well-intentioned individuals CREATED the false incentives and abnormalities in the market. This devastating asset “Bubble” in real estate and mortgage backed securities markets would not have arisen without specific leaders within the aformentioned Gov’t entities making specific policy decisions that dramatically increased consumer demand for these assets while at the same time arbitrarily reducing the concomitant risks of owning these assets; i.e., increasing the moral hazard we hear about so often. The whole process was in my view a fraudulent excercise perpetrated on the entire country. I could name names but I believe the readers of this are probably astute enough to understand who these people are that created this mess. Now we have many of the same individuals in the Federal Gov’t or those advising the Fed Gov’t, espousing an even greater control over the economy. We are allowing the Problem Creators to become the Problem Solvers. Come on. I wish I viewed the next few years as optimistically as you, but what is happening to our country’s economy and our future is frightening.

    Marisa says:

    There is a significant difference between a Ponzi scheme and a ‘bubble’. While the investors of each scheme are operating as fools, the con man who runs the Ponzi scheme is operating under the all-too true assumption that there are many fools who will become investors, bring in more investors and all the while there is NO product to invest in, just one man at the top surreptitously banking all of the money. That con man MAY dole out incremental interest payments to sustain the con, but the lion’s share of wealth is his alone.
    Whereas in the bubble scheme, an investor is operating as a fool alone (“greater fool theory” mentality) and making assumptions that there will always be a greater fool to buy his/her worthless good, whether that be in real estate, stocks etc. Someone believing that the market is going to continually rise, buying a home and attempting to ‘flip’ it only to find that the home they paid $1M for and invested $800k in not now in fact worth $1.8M but only worth $750k after the housing market crash, just as an example.
    It is the number of investors and whether or not the person intends on being fraudulent that defines whether an action is a Ponzi scheme or a bubble. Ponzi = Madoff, bad policy & deregulation by the federal government = housing market crash = bubble. Simple as that.

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